On Japanification

inflation is bad but deflation is terrible

I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments. - Friedrich August von Hayek

Fears over recession are once again stalking markets, but many people are more worried about a deeper, more structural shift: that the world economy is succumbing to a phenomenon dubbed “Japanification”.

Japanification, or Japanization, is the term economists use to describe the country’s nearly 30-year battle against deflation and anaemic growth, characterized by extraordinary but ineffective monetary stimulus propelling bond yields lower even as debt burdens balloon. People have long been concerned that Europe is succumbing to a similar malaise, but were hopeful that the US — with its better demographics, more dynamic economy and stronger post-crisis recovery would avoid the same fate. 

The malaise of "Japanification" burst into the mainstream, leaving in its wake a record amount of negative-yielding debt. Quantitative easing and a low interest rate regime in Europe delivered banner returns on the region's bonds - at the expense of bank profits and retirement savings. Many say it recalls Japan's lost decade. The primary symptom of spreading Japanification: the rise of negative-yielding debt.

It's a scourge that threatens to spread further - perhaps even to the US. The world's largest economy might only need a slide into a "plain-vanilla recession" to succumb to zero yields. The bottom line is this: even with tax, fiscal and social policies, once one enters a true deflationary period one will run the risk of deflation persisting. In short, deflation depresses asset values, contracts credit, and bolsters the purchasing power of currency.

The data below is from the last 20 years in Japan and it's clear that a deflationary spiral is nothing to mess with. The appearance of a secular stagnation and deflationary trend in the United States economy that closely resembles the issues Japan has faced over the last 20 + years is something that many need to brace for.

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets. - Peter Lynch

As a term of economic plight which is neither outright bankruptcy nor much better than a hall of mirrors, “Japanification” is derived from the events which led to, as well as resulted from, the two lost decades of Japan’s economy. This unraveling process involved a terrible destruction of wealth. It defied a horde of stimuli, which cost more than 150% of the country’s GDP but delivered no results; led to a deflationary environment and an impotent stock market; and crystallized business activity, leaving it unable to lift itself from the hecatomb into which it was thrown by the crisis.

The spirit of “Japanification” is now haunting not only Japan, but also US policy makers. A confounding macroeconomics puzzle since Japan’s economy stalled from mid-1990s, “Japanification” refers to the combination of high and rising government debt, anaemic growth and inflation, and unprecedented monetary loosening, alongside population aging. So, one can see how the US is now very akin to Japan of just a few short decades ago.

With Japanese central bankers recently, however, confessing that they have mis-diagnosed the cause of “Japanification” for decades, it is imperative that US policy makers don’t repeat their mistake. Innovation, fecundity and restlessness are needed for America to avoid the same fate as Japan.

Countless articles showcase some snippets of life in Japan. It’s troubling to see the human sides of deflation on the spirit and drive of the Japanese people and its impact on the culture. Low interest rates and government stimulus can't begin to solve the motivational and incentive problems of the world. Low interest rates do not motivate one to have children or create an inspiring business. However, sound economic infrastructure and limited government intervention can.

While Japan has been suffering from a deleveraging trend over the last 20 years, there has also been an incredibly powerful structural headwind – demographics.  Population decline is a structural headwind that puts huge inherent downward pressure on any economy.  To put this in perspective, here is the general trend in demographics between the USA and Japan:

The United State’s Japanification is also resulting from a structural headwind, but it’s a bit different. Instead of a daunting demographic trend (although it is happening in the US, but to a lesser degree). The USA is suffering from a structural monetary issue. The US, unlike many other first world countries (or the EU), doesn’t suffer from periodic debt crises resulting from trade imbalances because the US government acts as a massive rebalancer via the redistributive design of the system.  In other words, all states pay into a federal system and the states that are on the periphery are the ones who tend to get more federal aid. Revenue sharing… This helps bolster budget issues and avoid defaults. This system doesn’t exist in most of the world so they are essentially relying on alternative measures to make things work in the meantime.

GDP

Is there really a new roadmap to GDP growth?

First, GDP is a simple formula that is quite easy to explain. There are only a few ways to move the needle on GDP growth. We can consume a whole lot more, have our government spend more, we can invest more in plant, equipment and technology as businesses, or we can export more of what we make and import less of what "they” make. Everything else one reads about, listens to and watches, when it comes to economic policy feeds into those basic facts. So, what matters most? Consumption. Consumption accounts for over 70% of the US GDP formula.

Frugality is one of the most beautiful and joyful words in the English language, and yet one that we are culturally cut off from understanding and enjoying. The consumption society has made us feel that happiness lies in having things, and has failed to teach us the happiness of not having things. - Elise Boulding

What if

What if the "New Normal" meant less consumption by all of us? What would have to go up if we dropped consumption by 10% in the GDP formula? By the way, during the Great Depression consumption dropped by 41% so a 10% drop is not unimaginable.

One can see that all things being equal (ceteris peribus):

Investment would have to go up by:

• Investments by private business are strained by not having a clear picture of demand from the end consumer. However, we hear about accelerated depreciation ideas and R&D tax credits. These are all incentives to move the needle on planned investments by the private sector.

Government Spending would have to go up by:

• Government Spending is something that we’ve all heard a lot about in the last 18 months. We all know the spending spree the government is on and now we know why. It's controllable by them, it can have a major impact on the GDP formula and the government can almost manufacture any amount of GDP growth for a period of time (for as long as they are willing to borrow or until it all breaks down). Ideas like stimulus and road projects are a few examples of this component.

Imports vs. Exports would have to balance out by:

• Imports vs. Exports, or in other words, our Trade Balance. We know the current administration has said several times that we need to import less and export more. It’s not rocket science as to why. Ideas like bailing out poorly operated auto manufacturers, support for unions, trade wars, and our weak dollar all support this policy. One of the problems in playing with this part of the equation is that this is how real wars start. This is a topic that deserves its own article at a later date.

The bottom line, is that without Consumption restored the entire formula has limited chances of functioning well over the long term. There is no “New Road Map.”

It’s clear that:

• Any opinion leader, politician or policy maker is coming to grips with the reality that there are only temporary and likely unsustainable solutions without the consumer.

• Without demand from the consumer, prices of everything will drop until they find a new equilibrium level (deflation). This is bad.

• If deflation is persistent, i.e. the loss of value in the housing market, stock market, real wages and income. Along with higher rates of poverty, unemployment, under employment, low overall demand), then we will not be far from “Japanification”.

Remember, this is also a behavioral phenomena and not just an economic one.

No one, wants to see the lost decades of Japan come to the US. So one can expect the Fed to react in the extreme with more quantitative easing, all while the government tries every policy trick in the book. This is especially prescient now (writing in June 2022) as elections are around the corner. This will be aided by the media in ways we are all familiar with, the power of propaganda is underrated. Even academia will get involved by encouraging all kinds of ideas to fix the formula or change the mix of the formula.

In sum, the real economy will likely limp along and the stock market and financial economy will likely benefit from all the attempts to re-inflate the economy in the short run. Perhaps this is the next bubble creator. The human spirit of investment, speculation and desire for more will be muted There is no “New Road Map”, just attempts at fixing the road we have always traveled on.

Hold steady, but be prepared for very choppy seas ahead, so lengthen one’s time horizon and reduce multiyear return expectations. Cash will be King in the short term. Rough seas can mean bad decisions especially when it comes to liquidity constraints.